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It seems like discussion of Piketty’s Capital has run its course and much of the commentary has moved on (though not necessarily from the broader topic) so now is as good time as any to peer back and reflect on how the debate around the book ended (if such a thing can be summarized). From my own vantage point, the debate about the book (not necessarily the discussion) stalled out around a single question, so I will do my best to restate and clarify that question so as to focus where more evidence and argument is needed, should this be a conversation anyone wishes to resume. None of this is new, exactly, but it’s worth recanting given the importance of the question and the stakes surrounding it.
Around 1800 AD, living standards in some countries began to rise substantially, and over the past 200 years, that rise (as measured in GDP per capita) has been on the order of a factor of 50. This generally seems to correlate with other indicators of increased living standards to a degree that, with some exceptions (such as thinly-populated resource-rich countries) it is generally, though not universally, accepted practice to use GDP per capita as a good-enough shorthand for broad living standards. Whatever the case, exactly how and why this increase transpired is still a matter of debate, in no small measure because most people would find it desirable to replicate the phenomenon in those areas that have not yet experienced it. Indeed, some countries that did not begin experiencing the phenomenon in its initial emergence have experienced it since, leaving, essentially, three groups of countries – those who have experienced it, those who have not, and those in transition.
Piketty’s book, while not exclusively, overwhelmingly is focused on the first kind of country. A compelling portion of his narrative is documenting that transformation, yet the broader focus of the book is on what has transpired since that transformation was consolidated in the era following the Second World War. There are two key factors to be documented. The first is that the countries that have fully experienced this transformation are themselves not ‘complete’ in this regard – average living standards (recent economic troubles excepted) continue to rise and are generally, though not universally, expected to continue to rise in the absence of extreme calamity on the scale of global catastrophic climate change. The second is the change in the distribution of income – since a moment of ‘peak equality’ in roughly 1970, most of the countries Piketty analyzes have seen a sharp increase in inequality, the specific degree of which dependent on method of measurement but whose general contours is not really disputed. This, Piketty and many other believes, poses a problem for these countries that is not alleviable solely by continuing increases in average living standards or aggregate wealth and income growth.
Piketty devotes a lot of space to developing a simple model of how the aggregate quantity and distribution of capital can drive income inequality. This remarkably simple model requires only three input variables – the growth rate of the economy, the average return to capital, and the savings rate (perhaps better phrased as the rate of capital formation relative to national income) – to generate a long term prediction of two key ratios: the ratio of capital to income, and the capital share of national income. From there, wealth inequality can be used directly to compute a floor on income inequality – for example, if 1% of the population owns 50% of the national wealth and the capital share of income is 30%, then that 1% captures, at a minimum, 15% of national income.
And here we arrive at the crux of the debate. Piketty’s model implicitly assumes a certain exogeneity between those three input variables and the two ratios they converge towards, ie, that they are not inherently correlated with each other. This exogeneity poses a fragility in Piketty’s model and a challenge to mainstream economic theory. The fragility is that, if they are strongly correlated (in the direction such correlation is expected), and especially if there is iterative feedback between them over time, then Piketty’s model no longer produces outcomes in which wealth inequality drives income inequality. The key example here is the average return to capital; were it to fall in proportion to the rise of total capital accumulation, then the capital share of national income would be invariant to the quantity of capital, and thus largely undermine the mechanism by which present wealth inequality drives future income inequality. Furthermore, were this anticipatable decline in the in return to capital to drive a decline in savings, the capital/national income ratio would converge at a substantially smaller value than that projected by extrapolating from the initial period. This further depresses the likelihood of ever-increasing wealth-driven income inequality.
This is also precisely the challenge to mainstream economic theory. These correlations and feedbacks are precisely what are predicted by fundamental, strongly-held ideas about economics held by economists; most centrally that investment behavior is driven by that most central economic force, supply and demand. Piketty, however, is not simply laying down an alternative model, but an empirical challenge to this challenge. The most crucial assertion made by his model – that the return to capital fails to decline in proportion to the supply of capital – is not simply a theoretical alternative but one derived from the meticulously researched and calculated estimates in his unprecedented data. As I myself pointed out in my write-up of Piketty’s book, the data show that the return to capital is sufficiently resilient to its accumulation to justify Piketty’s model. At least, that is, without controlling for any additional factors.
And here is where debate stalled, with one side asserting that theory demands these variables be tightly correlated, and the other side responding that empirics demonstrates that they are not. The problem, of course, is that macroeconometric panel empirics is extremely sensitive to model specification, to the point of being perhaps the perfect example of how any decent statistically-versed researcher with strong priors can generate the outcomes from the data they which to receive. Certainly it is more than possible to generate a superfluity of complex models demonstrating the theoretically-predicted correlations, and these models will collectively have zero persuasive power because it is trivially easily to create as many or more equally-plausible equally-complex models that demonstrate the obvious.
Why does this all matter, to the degree it’s worth recounting in such detail to the tune of a thousand words? Because it strikes directly at the heart of the most important argument for tolerating high income inequality.
There are basically three arguments in favor of tolerating high income inequality, which I will attempt to summarize as fairly as I can.
- The ‘Just Deserts’ Position: incomes reflect the inherently just outcomes of markets. Beyond a certain threshold to prevent the worst form of miseries, it is therefore a violation of justice to take from the deserving and distribute to the undeserving.
- The ‘Pink Salt’ Position: income inequality is irrelevant except to the irremediably envious, resentful, or spiteful. What matters is preserving and increasing human happiness, which is largely driven by civil liberties, non-market institutions such as family and community, and the secondary impacts of economic progress.
- The ‘Golden Egg’ Position: income inequality may be ceteris paribus bad but aggregate economic growth is extremely good to a degree that in most plausible scenarios swamps income inequality. Furthermore, income inequality and economic growth may be conjoined outcomes of our economic system and cannot be modified independently. Therefore, we should be extremely cautious about attempting to alleviate income inequality through policies that slow the rate of economic growth, as this may reduce not just aggregate utility but the utility of those benefiting directly from redistribution.
It will shock nobody to hear that I reject outright the first argument in the strongest possible terms, and the second in quite strong terms as well. Indeed, I believe that the majority of Americans, and certainly the majority of voters in developed countries, disagree with those arguments as well. It is that third argument that gives pause to many – including, to a degree, me (though that pause is still far from convincing in my own case). The average person living in a developed country today as compared to a person living in that same country in 1800 is vastly better off, and it is not impossible to imagine that the average person living in a developed country in 2100 will be vastly better off than that average person today. Impeding our shared progress in that regard could simultaneously defer developments that improve the quality of most lives while simultaneously deferring developments (like innovation in renewable energy sources and storage) that could mitigate or reverse the worst consequences of economic growth to date.
This all converges on something of an ironic surprise. In this debate, it has been the left that has been advocating, implicitly or explicitly, on behalf of the resilience of capitalism (broadly defined) and its ability to deliver human prosperity, whereas it has been the right that has claimed, implicitly or explicitly, that capitalism and the prosperity it delivers is fragile, so much so that even increasing post-market redistribution (as opposed to pre-market regulatory redistribution through minimum wages, stronger protections for unions, and abridging the current rights and privileges of lenders and shareholders) could, to use a tired aphorism, kill the goose that lays the golden eggs. This ideological positioning isn’t wholly novel, and whether it is instrumental and ephemeral or representative of something larger remains to be seen; but it is notable, and worth pondering for what it says about the state of both the contemporary mainstream left and right movements in the United States (if not beyond).
This, of course, is an increasingly common view in the “internet wonk community” (one I consider myself an member of), distinct from the related and equally-prevalent view that ‘homeownership should be much less subsidized than it it now.’
This is also a view I take issue with, which you’d already know if you read my big Piketty #thinkpiece – you read my big Piketty #thinkpiece, right? right? – and one that I think needs a little elucidating and defending in detail.
There are three basic reasons that buying a house is a vastly better investment than current wonkpinion suggests. The first is that making large leveraged investments can pay off hugely even if the underlying growth rate of the purchased asset is slow. Let’s demonstrate.* Let’s take an average American buying an average house in an average way – $200,000 purchase price, 20% down, 4% closing costs, 5% interest rate. Now let’s say the value of that house grows reeeeeeeally slowly – just 0.3%/year, which just so happens to be the compounded annual growth rate of the Case-Shiller index since 1947.
If our average American sells their house after 10 years, their initial $48,000 equity investment will become $67,691.08 – which means their equity grew at a CAGR of 3.5%! If they sell after 15 years, they’ll net $92,209.57, which is a CAGR of 4.45%. Hey, that’s a lot higher than the 0.3% growth rate of the house’s price itself, isn’t it?
It sure is! The amazing power of leveraged investments is that you can turn a little bit of equity into a large return, as Matt Yglesias notes concisely here. Here, in fact, is a nice little graph demonstrating the implied return rate of selling your house after making regular mortgage payments for a given number of years, given the interest rate paid, assuming that meager 0.3% growth rate:
After 13 years, you’ll get a 3% return even at a very high interest rate; at 19 years, you’ll get a 4% return. In fact, you can assume zero growth and still get a substantial return on your initial investment – as long as you don’t count the regular payments on the debt.
Hey, what about the regular payments on the debt?
Good question! This brings us to my next two points. Because if leveraged investments are so awesome, why don’t we empower (and perhaps subsidize) average people to make large leveraged investments in stocks, which have a much larger underlying growth rate? Beyond all the other problems with that idea (not that nobody has pitched it), the thing about a house is that it has an unusual counterfactual. If you buy stocks with leverage, in theory the payments on the debt should come out of your savings, creating a counterfactual of simply saving and investing that money. But the counterfactual to owning is renting. This creates some curious conditions that lead to my next two points in favor of buying a house – inflation protection and subsidies.
There is obviously some connection between the purchase price of a house (and therefore the amortized monthly payment on the mortgage) and the rent it could fetch – regardless of where you fall on the capital controversy that dare not speak its name, there must be some fundamental link between the price of an asset and its expected returns. However, a mortgage is detached from the imputed rent (the flow of sheltering services) a house delivers, and therefore is nominally frozen in a way that rents are not. So therefore even if a mortgage today is substantially more expensive than the rent payment on an equivalent housing unit, in thirty years even very low inflation will change that drastically. Just 2% average annual inflation entails an 80% increase in the price level over three decades, meaning the annual mortgage payment declines by nearly half over that time. Rent, in the meantime, keeps going up (except in rare cases which can entail its own problems), at least as fast as inflation. Therefore even a mortgage whose monthly payment is more expensive than a rent payment today will be much cheaper than renting in a few years.
Aha, you might say, but there is a problem with this – the magic of compound interest means that the difference-in-monthly-payment savings accrued today by the renter will be much more valuable in retirement than the parallel savings accrued years from now by the owner. This is true! But that’s where the subsidies kick in. Our primary national subsidy for homeownership is to allow mortgage-payers to deduct the interest portion of their payments from their income – and the amortization structure of mortgages means the share of payments comprised of interest are highest right when the mortgage begins, and declines until the loan expires:
This benefit comes when “housing” costs – really, housing-purchase-debt costs – are at their highest, also because earlier in life is when incomes are their lowest. It is difficult – very difficult – to defend the home mortgage interest deduction as currently structured, as such a large portion of the benefit goes to such a small and disproportionately well-off group. It is worth considering, though, whether the idea at the core of the program is sound. And either way, whether you think we should have them or not doesn’t mean that you don’t consider them when considering what constitutes a good investment under the status quo.
Of course, I haven’t even touched on imputed rents once a house is fully-owned (or, conversely, actual rents), which are of course the most important return to a house, well beyond the capital gains discussed heretofore. But this leads to the most important conclusion: not that houses are such a great investment per se; just that they’re a great investment for people without a lot of capital because of their unique pathway to leverage. If you had half-a-million dollars, should you buy a house (or apartment) to rent or a portfolio of financial products? Almost always the latter. But if you only have an order of magnitude less than that to your name, it may make sense to buy something with a lower return (not to mention wholly undiversified) because you can lever up. Just another way that large capital concentrations can secure higher returns – or at least exercise more freedom of action.
Spreadsheet, as always, attached – calculate your own expected returns on your housing investment!
*All of these numbers are real and net-of-depreciation unless otherwise noted.
So these are the three largest components of GDP, all indexed to 1960:
Clearly one of these is not like the others, but the well-known fact that investment, not consumption or government spending, is mostly what fluctuates with the business cycle is very visible. I wanted to dig a little deeper, though, especially to compare the current recession to priors. So I made this graph:
Bars are unbroken periods of percent change in GPDI; their height is the total percent change in the period, their width is the length.
Here it is smoothed a bit using a highly-advanced method called “arbitrary eyeballing”:
And this time with feeling:
While none of these three graphs is perfect, looking at all of them the various recessions we’ve experienced and their depth and breadth become quite clear. And it seems striking that our current mess represents a vastly larger and longer decline in private investment then any prior recession since WWII.
So let’s break down GPDI; the biggest component is the broad heading of “fixed non-residential investment:”
Looking at the log (which is quite often a good idea, see James Hamilton for more) you can see that this recessions seems notably but not dramatically more severe than past downturns, and that we are on a decent track for recovery.
But here’s residential structures:
Wowzers. Two facts worth noting: residential investment has fallen off a cliff and is nowhere near recovering; the so-called “housing boom” is barely visible.
That becomes a little clearer, though, when you look at single-family construction vs. multifamily and “other” (dorms, trailers, etc):
Single-family construction clearly gets a little wacky during the mid-aughties, whereas multifamily is catching up from slacking on trend; since then, multi-family is rebounding while other is wishy-washy and single-family is really terrible.
What’s remarkable about all this, though, is that you can with some confidence say non-causally that recessions are, for all intents and purposes, fluctuation in housing construction.
In the past, we’ve had recessions, interest rates are cut, recession over. Now, interest rates can’t be cut, and we’re not building enough housing, and therefore there’s too much unemployment (especially among the young who are largely the building class):
In fact, relative to older folks, this is the worst the young have had it since the 70s:
Now, why does lowering interest rates reverse recessions? There are many good reasons, but to some extent they’re all about setting expectations. When the Fed “cuts rates,” what is doing is what its doing is just buying lots of government securities, which is what “quantitative easing” is; the difference between the former and the latter is the ends, not the means. The former is a kind of credible expectation setting of broader outcomes – “we will buy bonds until interest rates are where we say they should be, dammit.” The latter sets a much narrower expectation that doesn’t necessarily imply broader changes in the economy.
Now, there is an idea out there that Paul Krugman calls “the confidence fairy,” which he belittles…and he’s right (at least in practice)! As it is formulated by conservative pols and pundits as a partisan cudgel, it basically amounts to a non-sequitur; recessions, ergo, implement the tangential policies we support regardless of economic conditions (derp).
But I’m not sure the confidence fairy is entirely a fiction. In what I think is a bit of a cousin to Steve Waldman’s story of finance as the world’s most important confidence game, it seems like in the past recessions have been alleviated because the Fed creates self-fulfilling prophecies – by buying bonds to depress interest rates, they incentivize individuals to invest based on an implicit assumption about future growth dependent on their investment. And it all worked rather nicely until we hit the ZLB:
The thing that the Fed has fundamentally failed to do is pull their usual trick; they haven’t convinced anyone that the economy will be better tomorrow, so they’re not doing the things today that will create that improvement.
This, in a roundabout way, is where I get to responding to Ryan Cooper’s terrific article making the case for helicopter money. Helicopter money is a good idea. I like it. I support it. It is a humane, fair, and efficient way to help everyone get through hard times. But my gut tells me its not, on its own, enough to kickstart us out of the funk our economy is in. While the biggest reason the 2008 tax rebate didn’t help the economy was its puniness relatively to the impending crisis, it was doubly hobbled by the fact that it was a one-off with no guarantee of being repeated (which it hasn’t, though the payroll tax cut was it’s cousin). Ryan supports giving the Fed the power to mail checks unilaterally, not by implicitly supporting a fiscal-side program, which is a great idea – coordinating the king and the wizard can be a tricky game. But even then, a $2000 check can be extraordinarily helpful in the medium term to people in need, but it in-and-of-itself does not a housing construction recovery make. Helicopter money works best, and may work only, as the whip hand of a credible promise by the Fed of meeting a broader economic target; it can, though, be a very persuasive whip.
“People respond to incentives.” That is a mantra, a shibboleth, a totem of economic thought that is various touted, invoked, and at the very least accepted by partisans of all sides and factions – it’s one of the core tenet’s of Mankiw’s textbook, for example. But getting beyond the fact that in some sense it’s a tautology, the statement strikes me, after some thought, as weirdly determinist.
One could, for example, create a model where “people respond to incentives” but what any given individual is incented by, or incented towards, is completely random – money could make some people vomit, while other people do ten jumping jacks every time they see a labradoodle. But that’s not what economists mean when they say “people respond to incentives.” What they mean is that there is some identifiable set of circumstances and stimuli that people will, in aggregate, respond to predictably.
Far be it from me to dispute this, at least directly – certainly you could imagine a world where the micro can seem random but the aggregate can seem largely predictable, but you could also imagine a world where forces outside that identifiable set of circumstances and stimuli have a sufficiently large and unpredictable effect on aggregate human behavior, and, further, interact with those circumstances and stimuli in volatile ways, thus at least partially rattling, if not undermining, the foundations of a system of thought based on those incentives.
What I really want to talk about is determinism. Because it is weird, at least a little, to me that some of the people who most vigorously and vociferously intone “people respond to incentives” as a devotional are the people who also most vociferously support “individual freedom” and voluntary action. It’s not so much that there is a contradiction per se as much as an odd combination of stress – why is it so important that as much of the human sphere as possible is structured to be voluntary if the effects of any given system are largely predictable?
What led me to this thought was Doug Henwood’s fascinating interview with Penny Lewis about the myth of the hard hat/hippie divide in which she refers to the post-Vietnam volunteer army as being the “economic draft.” Now this is, in some sense, self-evidently true – it is difficult to imagine a situation in which a volunteer army offering sufficient pay and benefits would fail to find recruits. But it also seems that it would be important to people to feel as though joining the army was voluntary on an individual level, regardless of the aggregate fact that the army will invariably recruit around the number of people it wants to assuming it knows how to set pay and benefits accordingly. My question: is the “voluntariness” of the army important because it increases efficiency (ie, recruits are self-selected rather than compressed at random) or is it because it is somehow just? What if you could create a non-voluntary system that guaranteed a similar level of efficiency (not that hard, when you consider that a decent chunk of enlistees have, er, ulterior motives) – would that be equally just to a volunteer army? If not, why is the voluntariness of the moment of enlistment so crucial? Wouldn’t it be more just, in some sense, to compress and pay less and thus tax less? Taxes aren’t voluntary.
This rambling inversion of Nozick’s Wilt the Stilt thought experiment doesn’t really go anywhere, but it is also worth noting that I stumbled upon this little essay on why leftists are necessarily determinists by Benjamin Studebaker. Notably, it goes wrong logically at precisely the moment it goes wrong factually:
The right very strongly disagrees with the left on this. Remember “you didn’t build that“? The right was furious about Obama’s claim that businessmen were not personally responsible for the success of their enterprises. Obama tried to back-peddle on the comment, but he had no business doing so, because “you didn’t build that” is precisely what leftists believe. Leftists don’t think that the rich are to credit for their success or that the poor are to blame for their failures. Leftists think sociological and natural forces determine who succeeds and who fails. People who succeed benefit from genetic advantages, better parenting, better education, more opportunity, more help from the state, and so on. People who fail lack these advantages and often possess their inverse–genetic disadvantages, bad parenting, bad education, less opportunity, less help from the state. To the extent that you are genetically gifted and enjoy a good environment, you succeed. To the extent that you are genetically shafted and suffer from a poor environment, you don’t.
Sigh. I am loathe to engage with anyone who presents any interpretation of Obama’s “you didn’t build that” comments other than the correct one for fear of engaging with someone deliberately uninformed or un-invested in good faith, but it’s worth explaining one last time, I suppose, that Obama’s comments were focused on something indisputable and very, very important – the intergenerational compact of public investment. Here’s how it works.
I am alive in some present. In the present, society has the capacity to produce some sum of material resources and intellectual discovery. Certain kinds of production – such as the production of pointlessly-large exurban houses in the Sun Belt or flat-screen televisions – are largely present-oriented and disconnected from future prosperity, while other investments – like building and maintaining transportation and utility infrastructure or scientific research – are largely-future oriented and necessarily divulge the vast share of their benefits to future generations regardless of how fast they convey present investment into future benefit. The Interstate Highway System, for example, certainly provided some benefit to those who were born during the Eisenhower administration, but assuming they are well-maintained could theoretically produce benefits to future generations ad infinitum.
Now, those benefits, while increasing net prosperity in myriad ways measurable and otherwise, do flow in lumpy ways. For example, if you founded a large trucking enterprise in the 1960s when the Interstate Highway System was just being built, you are likely really, really rich today. And if you, say, founded an internet shopping website when the internet was just getting started you, too, are likely really really rich today because of both public investment in making the internet possible and the highways that actually bring goods from fulfillment centers to homes at almost the speed of click.
This gets back to the argument Obama was making. Obama wasn’t making some puzzling point about entrepreneurs being winners of an arbitrary genetic and environmental lottery to justify their expropriation; he was making the very obvious point that many, if not all, of the people who are rich today are rich because past generations made sacrifices to invest in the infrastructure that made their success possible and therefore they should hold up their end of the intergenerational compact and help fund the public infrastructure of today that will create tomorrow’s broad-based prosperity and billionaire entrepreneurs alike. Nothing about this requires a belief ether way about determinism or free will, just the practical observation that quality public investment breeds prosperity which makes entrepreneurs possible (remember Woody Allen’s point about being a savannah tribesman) and the argument that those who benefited from past investment the most should probably pay a larger share of the costs of current investment for reasons of both fairness and ability. Therefore Studebaker’s conclusion that:
If we deny that the universe is determinist, there is no ground for objecting to the right’s argument that some people will themselves to success through virtue and others to failure through vice. If there is any other element, if there is any independent will, then some people really are fundamentally better people than others, are more deserving than others, and should be rewarded on that basis alone.
Is both incorrect and misses the point that that causes of why, say, Bill Gates or Steve Jobs got really rich is separate from the point that public investment in universities and computer technology and the internet and patent protection made someone getting really rich pushing forward the boundaries on computing all-but-inevitable and therefore whoever that someone is should help fund high-speed rail or whatever.
Noah Smith mused about a subject I’m interested in – the fundamental conceptual issues at the nature of saving – in a way I like to muse about it – thought experiments – so how could I not deconstruct his post in excruciating detail?
Specifically, I’d like to focus on the economy of his deer hunter (one of many, in his example, but just one for this purpose): a man who lives, alone, in the woods, hunting deer. I’m going to break this down as much as I can while abstracting away the non-deer parts of his economy (shelter, clothing, tools, etc). Because the deer hunter is an economy – and while he might be an economy of only one human, who we’ll call Vronsky -, we can productively and fruitfully view him as a vertically-integrated economy, and break him down into four sectors:
1) A firm that hunts deer. The firm locates as many deer as possible and kills them, then sells them to the next sector. It has most fixed costs (labor to hunt deer) and therefore pays relatively fixed wages, the rest collected as profit.
2) A firm that processes dead deer into venison. This firm always purchases all the deer killed by the first firm, and always sells all of its venison to the next two sectors. It has more variable wages (because it has variable labor as its primary input) and takes the rest as profit.
3) A firm that stores processed deer. This firm always buys all the surplus venison produced by the processing firm, salts it, and stores it until there is a market for it. We will discuss its economy in more detail below.
4) The consumer. It always buys a certain amount of venison (let’s call it C) no matter what.
Now, in actuality, all these firms are the same person – Vronsky, who owns all the firms, provides all the labor, and collects all the wages and profits (which he then proceeds to, largely, eat). But we can break the internal economy of his life away from Williamson-ian integration and imagine a market that works something like this:
There are flush years and lean years – periods, that is, in which D (the amount of deer caught by the hunting firm) is either greater than or less than C. Let’s see what happens in a flush year.
The first firm kills some amount of deer, D, that is bigger than C (we’ll call it C + S). It sells C + S deer to the second firm, pays its wages, and collects profit (let’s imagine the firm breaks even in years when D = C).
The second firm processes all the deer into venison, and sells C venison to the consumer and S to the third firm. This firm always breaks even because its labor varies in direct proportion to its production which varies in direct proportion to the available venison.
Now, the third firm. What should be clear is that the third firm is the closest this economy has to a financial sector – it buys venison when it’s plentiful and sells it when it’s, er, dear. This means it, essentially, stabilizes the internal price of venison (and also raw deer). It also is a very different firm from the other two, since labor is a minimal input – it is a capital-intensive firm that specializes in storage and market mastery (we’re assuming it inherits all the capital, physical and intellectual). Assuming our flush year is t=1, the firm has costs – purchasing the venison, salting it, and storing it – but no revenue. Which means it has to borrow. From whom? The consumer’s wages should always = C, so it must borrow from the profitable sector of the economy – the first firm, who has profited from a plenty of deer to kill. Essentially, the amount of raw deer necessary to produce an amount of venison = C costs exactly the wages of a year’s worth of deer hunting, and the wages of processing the deer into venison are equal to the mark-up of venison over deer, meaning all the profits flow to the first firm – the hunting firm. So it loans the money to the third firm, the storage firm.
This works in reverse in lean years. In a lean year (let’s say t=2 is exactly as lean as t=1 is flush, so C-S) the hunting firm is in the red, since it pays wages beyond it’s revenue. However, it can call in a loan from the storage firm, which has almost no costs incurred but suddenly tons of revenue from selling its surplus! So it can pay back the loan to the first firm. So there are now no net savings, nominally or physically. Balance. Om.
But let’s say there isn’t long-term balance. That creates two potential scenarios – one of long-term scarcity, whose end is obvious and really quite sad for poor Vronsky. But long-term plenty is more…interesting.
If there is long-term plenty, a couple things could happen. If we are speaking strictly ceteris paribus, then we would see larger and larger imbalances between the accumulated bonds of the hunting firm and the accumulated debt of the storage firm, ending in…financial crisis! Salted venison doesn’t last forever, so it would be essentially squatting on toxic assets it would be loathe to revalue without the projected revenue to pay off it’s accumulated debt. It would go belly-up, and basically need its loans forgiven – by which we mean, of course, that Vronsky has to write off a lot of old, stinky venison into the river.
But assuming non-ceteris paribusity, what we would actually see is that, as salted venison becomes plenty, prices decline to the point where no amount of hunting can support the wages of the hunting firm. To skip the boring stuff, what happens is that Vronsky consumes more leisure as he eats down his stock of salted venison and takes up whittling or something.
Now, over the truly long term, endless plenty absent productivity increases is impossible for Malthusian reasons unless you want to assume a Children of Men kind of deal. But even there, we wouldn’t see infinite saving because Vronsky would, sitting on a giant pile of meat, only hunt to the extent he wanted to, not needed to.
The key, in the end, is this – that saving is just as much about production than consumption, and it’s really about the future-orientation of production. In a world where Vronsky is alone, and has no reason to invest in future growth, he won’t endlessly stockpile venison because of diminishing returns and will therefore shift to other forms of spending his time. But in a world where Vronsky was future-oriented, at least minimally, he might spend his savings to create extra time he could use to develop more efficient hunting tools, thus saving even more time in the future. Or he could develop a game that would amuse him. Or he could pack a sack full of salt venison and go on a quest to find a friend, or at least a basset hound.
The real point, in the end, is that nominal savings (which always equal nominal debt) are very disconnected from whether current production is creating value for the future. In the 00’s we simply invested too much of our productive capacity in building overly-large houses in low-cost but low-value locations, which created a lot of nominal debt and therefore nominal savings but didn’t enable the United States to be more productive in the future. On the other hand, higher taxes that built high-speed rail wouldn’t show up as saving, but from the perspective of society, we would be deferring fleetingly pleasurable consumption of movies and candy and craft beer and what have you towards building valuable infrastructure that would make us richer in the future. That’s not nominal savings, and in the short-term GDP looks the same, but that’s true saving in the modern world.
Miles Kimball and Yichuan Wang find that high government debt doesn’t cause low GDP growth, and Kimball says he finds that surprising, as does Matt Yglesias. But as I suggested in a post last month, I’m not really surprised by this at all.
Governments tax or borrow. The former is withdrawing money from the economy in exchange for nothing (or perhaps a promise not to sanction the taxed) while the latter withdraws money from the economy in exchange for a piece of paper. That’s debt! Evil, evil, debt! Oh, no!
Wait, let’s start over.
The goverment decides it wants to do something it isn’t already doing, and therefore needs to command a higher share of total social production going forward than it has been. Developed-world governments don’t directly commandeer social resources, they claim through the proxy of money, by spending it. Assuming an economy at full capacity (whatever that means), if the government commandeers resources by spending money without removing any money from the economy then you’d have inflation, unless the central bank raises interest rates substantially, which would likely have undesireable negative effects. So the government attempts to roughly balance the resources claims it makes using money by withdrawing an equivalent amount of money from society. Sometimes it does this through taxes, which has some desireable properties (no future obligations on the state, can be used Pigovianly) and some undesirable ones (unintended consequences, involuntary, discourages desireable activity). Borrowing also has some desireable properties (voluntary, compensates those who part with their money) and some undesireable properties (obligates the state).
Therefore, there are two key intertwined questions to be asked about this new government activity, which remember is centrally about taking some resources deployed previously to some private purpose and redirecting them to some other, presumably public purpose – is the new activity more valuable than the activity(s) it is supplanting, and how is it being financed? They are intertwined because the latter question informs the former.
Let’s say we all agree that this new government project – let’s say it’s a SUPERTRAIN, for fun – is widely considered to be of higher value than the marginal private activity it supplants regardless of how it is funded. The government could raise taxes to fund it, but unless it is taxing something undesireable (like carbon or booze or Kardashians) this would have the drawback of incurring some "deadweight loss," not to mention other unintended consequences. It could also borrow the money, which would have two consequences. Firstly, it would supplant something different – rather than raising the cost of work or carbon emissions, it would be more likely to supplant a capital investment of some kind somewhere in the economy. Secondly, it would obligate the government.
And to what would it obligate the government? Key to understanding this is that governments, unlike Lannisters, never pay their debts. They cleverly disguise this fact by paying their debts in full and on time. Huh? From the perspective of a borrower, you get your interest payments, and then your principal in full. But from the perspective of a government, you don’t pay the principal back out of tax revenue, you pay it by rolling over the debt and issuing new debt in the amount of the principal. This works because of NGDP growth (both the RGDP growth and inflationary components). In fact, we’re still likely rolling over all the debt we incurred from WWII, which back then was 110% of NGDP but today is less than 2% of NGDP.
So really what the government does when it issues a bond is issue itself a negative perpetuity. And the key to understanding the value of a perpetuity is knowing the interest rate, since the PV = C/r. Therefore, the obligation on the government is much more dependent on the interest rate path than on the nominal coupon value.
But that interest rate path isn’t just some made-up thing – it’s fundamentally related to NGDP growth. Don’t believe me? Here’s the fed funds rate divided by the NGDP growth rate:
So when recessions happen, the ratio spikes (and whether it spikes up or down is very interesting), but otherwise it’s very steady; if you exclude just the 12 of 223 periods where the absolute value of the ratio is greater than 3, you get an average of 0.8 and a standard deviation of 0.6.
So what does that mean? As interest rates grow, so does the obligation on the government – but it also implies that the government’s ability to meet that obligation is growing in tandem. Which suggests that, while governments cannot borrow limitlessly, the pain point at which government indebtedness begins to inflict structural economic harm is vastly higher than previous assumptions.
Japan, for example, is often cited as an example of government debt creating a huge drag/time bomb/giant vengeful lizard that is harming Japan’s economy. But since 1990, Japan’s debt/GDP ratio increased from 67% to 211% and GDP-per-capita…grew! Significantly! Not awesomely, not enough to catch-up with the US (in fact, it fell behind), but grow it did. Certainly more than you might think it would if the 90% monster were real and starting smashing major cities or something.
Many people have begun to worry whether the seemingly-inevitable Japanese debt crisis is nearing as yield have crept up. But yields have crept up because NGDP-growth-expectations have crept up. As long as they increase in tandem, contra Noah Smith, Japan should always be able to pay its debts.
And I’d be willing to put money/my reputation on this point. While Noah Smith is 100% right that bets != beliefs, I am nonetheless willing to agree in principle to any reasonably-valued bet that neither Japan nor the United States will default over any arbitrary time period. Any takers?
Responsible prudent savers. Totally ants.
Scott Sumner, lingua in bucca, swapped Formica for granite countertops and writes:
PPPPS. Yes, granite is very durable, which makes it investment . . .
. . . and of course saving too!
This, of course, goes to one of my hobbyhorse points – the exceptionally fuzzy line between "consuming" and "saving." The better way to view the world, IMHO, is one in which, beginning at some arbitrary point, we apply our time and existing stuff, through the media of institutions, to make more stuff, and that stuff varies in function, quality, durability, etc.
This also reminds me of a tangential point – young people, on average, probably do not travel anywhere near the optimal level. Travel can be expensive, but when you are young there are two factors that mitigate strongly in favor of travel. Firstly, you are most able to enjoy it. Let me tell you right now that future 50-year-old me would have had a way tougher time enjoying Mehrangarh than the present 26-year-old me. Secondly, travel is a perpetuity, and while most of their utitlity is illiquid, that’s as much an advantage as disadvantage – nobody can expropriate, steal, damage, or tax it.
This is much the same as education, which is why education debt is a bad idea, but while a college degree can be so expensive most people simply cannot fund it out of current consumption, an unforgettable month-long jaunt through India for two can cost less than $5000 including airfare, adequate lodging, and all consumption. Which is a lot, but if you have a young cohabitating pair with no kids making at least a combined $70-80k, as long as their rent isn’t too expensive and neither is drowning in debt it’s perfectly possible to save adequately for such an adventure over less than a year. And you could make a very strong argument that traveling while young is just as much "investment" (in something that produces a lifetime-long flow of happy memories and increased knowledge and wisdom, as well as fun stories to share with others) as "consumption."
Humans like categories. And for good reason – they make the world computable. Unfortunately, they can have the side effect of predigesting the world for us, so especially when it comes to concepts that are wholly or mostly abstract, we should be doubly on our guard against firm deliniations against what is “x” and what is “not x.”
More often, “x” is better used as an adjective and not a noun, not a class of thing but property that a thing can have more or less of or be more or less consonant with. JP Koning is a terrific advocate for this approach, as he explains why is blog is called “Moneyness:”
The second way to classify the world is to take everything out of these bins and ask the following sorts of questions: in what way are all of these things moneylike? How does the element of moneyness inhere in every valuable object? To what degree is some item more liquid than another? This second approach involves figuring out what set of rules determine an item’s moneyness and what set determines the rest of that item’s value (its non-moneyness).
Here’s an even easier way to think about the two methods. The first sort of monetary analysis uses nouns, the second uses adjectives. Money vs moneyness. When you use noun-based monetary analysis, you’re dealing in absolutes, either/or, and stern lines between items. When you use adjective-based monetary analysis, you’re establishing ranges, dealing in shades of gray, scales, and degrees.
Not only do I wholeheartedly endorse this approach re: understanding money, I think the methodology should be expanded to all kinds of other things. For example – a feature of much libertarian thought is trying to decide whether or not something is “coercive.” I’m not a libertarian, but I am emphatically not trying to concern troll when I suggest a better avenue to pursue is trying to weigh whether different things are more “coerce-y” than other things.
This brings us back to “savings” vs. “consumption,” or “investment,” or “consumer goods” vs. “capital.” I really don’t like these distinctions, because as useful as they have often been in the past in the present they can often sow more confusion than anything else. I suggest we instead look at different goods having different levels of “saveyness” or “capitalness” – some goods last longer, some have more uses, some increase future productivity more than others. This applies to both the consumer side as well as the good side – ie, is a certain consumer decision “saving” or “consuming,” as well as is a certain good “consumption” or “capital?”
Think of a Twinkie. Twinkies are an odd product; on the one hand, they are a cheap, delicious, unhealthy snack; on the other hand, they are (at least according to legend) practically immortal. So is buying a Twinkie consumption or saving? Does it depend when you eat it? And for those who will say “but Twinkies aren’t an investment, they bear no interest, they just sit there” – so does money under the mattress, and nobody thinks that isn’t saving. More interestingly, from the perspective of the economy, for the most part it doesn’t matter what you do with the Twinkie. Obviously in the aggregate, if people buy lots of Twinkies for “saving” purposes as opposed to “consumption” purposes there might be fewer loanable funds, but if you were deciding whether to buy a Twinkie, stuff it in the pantry, and eat it in a year, or simply stuff a dollar bill in the pantry to buy a Twinkie a year from now, you’d still be saving the same amount…right?
Or think about what goods are “consumption” and which are “capital.” Got it? OK – is roasted coffee a consumption good or capital? Fine, that’s probably an easy one – since it only has a single use, it probably gets counted as consumption even though it is manufactured and increases productivity. What about a Keurig machine? What about my beloved ekobrew that allows me to turn fancy whole bean roasted coffee into a Keruig-produced cup of hot java? Are these “consumption” or “capital” goods? Does it matter if I’m a worker at a firm or a sole proprietor? If Google had a giant coffee roasting and producing operation at the Googleplex as a perk for their employees we’d probably call the equipment they used to make the coffee “capital” – so is it merely a question of scale? If I buy it on Amazon, is it automatically “consumption?”
I think these conceptual questions are inevitable if we continue to rely on heuristical categories that don’t tell us much about modern life. Instead, any time we discuss a social production decision, we should instead ask ourselves questions – what does the good do? What inputs does it require to do what it does? How long does it last? How much does it increase productivity and happiness? How much maintenance does it require? What is it replacing or displacing, if anything? Asking these kinds of questions will tell us things about the nature of what we, as a society, are producing that are much more valuable than traditional delineations. For example, I think the United States, as a society, should be building more high-speed rail. High-speed rail is very “capital-y” – it lasts a long time and greatly increases productivity. I would be willing to trade substantial amounts of “consume-y” goods – candy bars, video games, new T-shirts – in favor of building more high-speed rail. Of course, the GDP calculation will show that as “G” and not “S/I” assuming it is built by the state – but it represents a social decision to produce more long-lasting, productivity enhancing, future-oriented stuff than it was before at the expense of more quickly-depleted, pleasure enhancing, present-oriented stuff. In the aggregate, that’s what “saving” is. It’s not a question of “more” or “less” but “what?” and “why?”
See also this book.
Hmmm, I wonder what would happen if everyone started saving as much income as they reasonably could? Where would the high yield investments be with so much capital sloshing around? How would the markets react when aggregate demand plummets even further?
Snark aside, the key here is that, while it would benefit any individual poor person to save more (assuming, of course, that’s possible given their income and cost-of-living, which is not an assumption I’m eager to make), if every poor person somehow stumbled onto Smith’s article and tried to save more it might generate economic disequlibria that wouldn’t benefit anyone. This is semi-related to the point I’ve made before that aggregate saving is a very different animal than individual saving.
IMHO, the best thing we can do for poor people is to a) give them money and other stuff (mostly healthcare), but perhaps more importantly b) make American richer so that we can more easily afford to give poor people money and healthcare. Public policy-wise, this mostly means investing in things that increase forward-looking productivity – high-speed rail, super-fast public internet access, etc. If America is richer tomorrow than it is today, than transfer programs can either a) grow without affecting the real net incomes of those paying for them or b) can remain at current levels of generosity while simultaneously allowing effective taxes to decline or making more public investment possible. That makes the political economy of the welfare state more sustainable and leads to a virtuous cycle. I don’t think it’s a coincidence that most wealthy nations have generous social safety nets.
Note that this is distinct from the right-wing trope that economic growth automatically benefits the poor because every time GDP grows golden coins rain from the flying limousines of the rich onto the heads of the grateful poor. The key is still in active support networks for the poor and the way that economic growth tends to strengthen them
Something that occured to me recently (I think it was after reading this post by Freddie deBoer but I don’t quite recall) is that, in all the talk about the problems surrounding escalating aggregate student debt and average individual student debt loads, nobody has quite made the case that all student debt is really, really stupid. So I will:
Student debt is really, really stupid. Debt is an instrument by which to finance an acquisition. There are many of them; debt is one. It is, specifically, where you trade a portion of your future earnings for increased present consumption, usually because you are purchasing something which it would be beneficial to own now but would take a long time for you to save for. If you’re talking about an individual, think house and car; a firm, big capital investments.
Of course, since we haven’t invented time travel (and even if we had if giving money to your past self changes the future we might trap ourselves in an infinite loop) you are assisted in this process by an outside lender, usually a bank or bankish institution, who assess you a fee for borrowing this money. However, a fee doesn’t quite solve the big inherent problem in this model, which is "what if you don’t give the lender the money back" which is why we invented collateral, which in addition to being an excellent movie is the formal name for "if you can’t pay the bill the bank takes your [thing you borrowed the money to buy]" and assuming your legal system functions sufficiently well then you’ve got yourself a financial system.
However, education poses two major problems to this model. Firstly, there’s no collateral – once educated, your education cannot be reclaimed or clawed back. Secondly, there are massive positive externalities to education – a more educated workforce is more productive, more innovative, and produces higher quality goods and services for everyone to consume. And the big problem is that these mitigate in opposite directions, the former against having an education loan market at all even though the latter makes widespread education hugely desireable.
We’ve kludged this together with a network of subsidies, but that has produced the status quo which obviously sucks in many ways. So what we really ought to do is try to think of ways to get students educated without using a primarily debt-based market to make the whole thing work, or a radically-altered one.